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Wall Street's Hands are Tied -- and That's a Good Thing

In recent weeks, stock market pundits have been wrestling with a
curious phenomenon. Trading activity has fallen sharply, which
these market-watchers presume to mean that investors have lost
interest in stocks. Mom-and-pop investors have likely become more
gun-shy this year. But the main culprit for lower trading volumes:
Wall Street's own trading desks.

Recent regulations have forced major investment banks to shrink
divisions that have used house money to bet on the stock market.
Some firms like
Bank of America (
BAC
)
are getting out of the business altogether. These "prop trading"
desks had been a solid source of profits, and Wall Street is surely
sorry to see them go.

The ostensible reason for these new regulations is that it makes
the whole financial system less risky. If there firms aren't
putting their own money at risk, they are less likely to fail. For
the rest of us, the demise of prop trading is a clear positive.
That's because Wall Street has just lost the incentive to save the
best ideas for itself for a while.

Just ask
Goldman Sachs (
GS
)
. Even as Goldman was telling clients to buy slumping housing
stocks and bonds in 2008, its own prop trading desk was betting
against housing -- kind of like a used car dealer pawning a
lemon
off on you.

The decision to shrink or exit the prop trading business won't deal
a sharp blow to the major banks. The prop trading divisions
typically account for just 8% to 10% of revenue, and since their
results can be very volatile, analysts don't tend to assign a high
value to their profit streams. Nevertheless, the fact that
consensus
earnings
forecasts for
Citigroup (
C
)
,
JP Morgan (
JPM
)
and Bank of America have held up even as its increasingly clear
that banking and trading business has slowed in recent months
should give you pause. Each of these firms is expected to report
quarterly results during the next two weeks, and their shares may
be vulnerable to a reduction in forecasts.

The steady wind down of trading at many prop trading desks is
already being felt as trading volume is clearly slumping.
IBM (
IBM
)
, for example, traded less than six million shares daily, on
average, in August and September. That represents the lowest volume
of the year, which is not necessarily a bad thing for large company
stocks. But lower volume means that bid and ask spreads on
micro-caps and small cap stocks may be a bit wider than usual (as
volume in a stock rises, market makers compete more aggressively to
fill stock orders and the bid/ask spread shrinks). So it makes
sense to place a
limit order
rather than market orders on these smaller stocks.

Shrinking volume
As noted earlier, declining trading volume is viewed as a sign that
individual investors have lost interest in stocks. But the
exchange-traded fund (
ETF
)
phenomenon brings that into question. Many exchange-traded funds
have seen a commensurate rise in trading volume that roughly
offsets the trading volume of individual stocks. For example, the
SPDR S&P 500ETF (
SPY
)
used to trade less than 75 million shares per day back in 2005. By
2007, that figure routinely exceeded 100 million and it now
averages more than 200 million. [
6 RulesETF
Investors Must Know]

The shift away from stock picking and toward ETFs tells you that
stocks in a specific sector are more likely to move in lock-step,
at least in the short-term, as these ETFS buy and sell all of the
components in tandem. For investors with a medium to long-term time
horizon, stock-picking is still a winning strategy as fundamental
factors like sales and profit growth will always be the long-term
determinant of stocks.

Action to Take -->
The demise of the individual investor is a current theme playing
out among market pundits. Don't you believe it. As the
economy
sputters back to life in 2011 and 2012, stocks are likely to find
newfound favor as they remain cheap by historical standards. The
fact that trading volume is light right now simply gives you more
time to sharpen your best research ideas. And as noted earlier,
Wall Street may be feeling some pressure from changing business
trends, but that's not necessarily a bad thing for you.

-- David Sterman

David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
More...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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